The Provisional Licence and the Group Audit
You are the engagement partner on the audit of Kestrel Holdings Ltd, an ASX-listed manufacturer with a 31 December year end. Planning begins in September for the December year end. Kestrel has eleven subsidiaries across Australia, New Zealand and Vietnam. Group revenue is $480 million; materiality at group level has been set at $3.6 million. The Vietnamese subsidiary, Kestrel VN, contributes 22% of group revenue and 31% of group assets, and holds the group's largest inventory balance. Kestrel VN is audited by a local firm, Sao Mai Audit, which you have not previously used. Sao Mai holds a valid local practising licence but is not registered with ASIC and has never been subject to an ASIC inspection. Sao Mai has offered to complete its work by 15 January, three weeks before the group audit report date of 5 February. Group management has asked you to accept Sao Mai's work without further procedures to keep fees down, noting the subsidiary has been audited by the same firm for six years without a reported problem.
1. Evaluate whether you can rely on Sao Mai Audit's work for the group audit, and identify the specific procedures you must perform before and during reliance.
Read the worked answer
Conclusion: reliance is possible but not automatic, and the fee pressure is irrelevant to the decision.
ISA 600 requires the group engagement partner to obtain an understanding of the component auditor, regardless of whether that auditor is in a different regulatory regime. The absence of ASIC registration and inspection history is a risk indicator, not a bar - but it shifts the burden of evidence onto you.
Pre-acceptance of the component auditor (do this now, in September):
- Assess professional competence and independence. Obtain Sao Mai's licence details, its quality control policies, and confirmation of independence from Kestrel group and Kestrel VN. Ask directly about any regulatory actions, peer reviews or litigation.
- Understand the regulatory environment. Vietnamese auditing standards and local independence rules may differ from Australian requirements. Identify where the differences matter - particularly on inventory observation and related-party disclosure.
- Communicate with Sao Mai. Agree in writing the scope of work, the materiality to apply at component level, the reporting deadline, and the form of their communication to you. Component materiality should be set below group materiality - for a component of this significance, a component materiality of roughly $2.0–2.5 million is defensible, with clearly trivial thresholds.
- Involve yourself in the risk assessment. Because Kestrel VN holds the largest inventory balance, inventory existence and valuation are likely significant risks. You must direct Sao Mai to perform procedures responsive to those risks, not simply accept their standard programme.
- Plan to review their work. Given the size of the component and the unfamiliarity of the auditor, review of their working papers - at minimum the inventory and revenue files - is warranted. Consider a site visit.
Timing risk. A 15 January completion leaves only three weeks for your review and follow-up. Build in a checkpoint in December so you see draft findings before the deadline, and reserve the right to extend procedures if their evidence is thin.
What you cannot do. You cannot accept Sao Mai's work because management wants lower fees, and you cannot treat six clean years as assurance - those years were not subject to your oversight. If, after these procedures, you cannot obtain sufficient appropriate evidence, you must either perform additional work yourself or modify the opinion under ISA 705.
2. Assume you proceed with Sao Mai. During your January review you find that Sao Mai's inventory observation was performed by an audit assistant with four months' experience, the working papers contain no test counts, and the conclusion reads 'inventory appears reasonable'. What is your response, and how does it affect the group audit report?
Read the worked answer
This is insufficient appropriate audit evidence and must be resolved before the group opinion is signed.
Why it fails. ISA 500 requires evidence that is sufficient in quantity and appropriate in quality. A conclusion of 'appears reasonable' is not evidence; it is an assertion. There are no test counts to corroborate the client's count sheets, and the observer's experience level compounds the risk that procedures were performed without adequate scepticism. Inventory is 31% of group assets and the largest single balance - this is a significant risk area.
Immediate actions:
- Request remediation from Sao Mai. Ask for the count instructions, the client's count sheets, the observer's notes, and any roll-forward or pricing testing. If these exist and were simply not filed, obtain and review them.
- Perform alternative procedures yourself. If Sao Mai's evidence cannot be salvaged, you must obtain evidence directly. Options include attending a subsequent count and rolling back, testing purchases and sales around year end, testing standard costs and overhead absorption, and testing net realisable value against post-year-end sales invoices.
- Escalate to the component auditor's leadership. A quality failure on a component of this size is a matter for Sao Mai's engagement partner, and it informs your assessment of whether to use them next year.
- Consider the effect on other balances. If Sao Mai's inventory work is deficient, question their work on revenue and receivables too.
Effect on the report. If you can obtain sufficient evidence through alternative procedures, you can issue an unmodified opinion - the deficiency in the component auditor's work does not itself require modification. If you cannot, the possible effect is material but not pervasive (inventory is one balance, and the rest of the group is audited by you and other firms), so a qualified opinion under ISA 705 is appropriate, with a basis-for-qualified-opinion paragraph describing the inventory balance and the limitation. If the deficiency extended across multiple significant components and undermined the financial report as a whole, a disclaimer would be considered - but that threshold is not met here on these facts.
Documentation. Record your evaluation, the alternative procedures performed, and the reasoning for your conclusion in the group audit file. Also consider whether the matter is a reportable quality issue for your firm's internal review.